Apr 28, 2024

Calculating Qualified Wages for ERC Audits

Calculating Qualified Wages for ERC Audits: A Comprehensive Guide

You’ve heard the buzz about the Employee Retention Credit (ERC) – that lucrative tax credit that could net your business up to $26,000 per employee for keeping workers on payroll during COVID-19, right? But, now that the IRS is ramping up audits on ERC claims, you might be wondering – did I calculate my qualified wages correctly? Well, you’ve come to the right place. We’re going to break it all down for you, step-by-step, so you can sail through an ERC audit with confidence. Let’s dive in.

Understanding Qualified Wages

First things first, what exactly are “qualified wages” for the ERC? Simply put, they’re the wages you paid employees during periods when your operations were fully or partially suspended due to COVID-19 orders, or when you experienced a significant decline in gross receipts. For 2020, qualified wages are capped at $10,000 per employee for the year. In 2021, it gets a bit trickier – qualified wages are capped at $10,000 per employee, per quarter.But here’s the kicker – whether all of your employee wages qualify depends on if you’re considered a “small eligible employer” or a “large eligible employer.” Let’s break that down.

Small vs. Large Employers for ERC

For 2020, if you had 100 or fewer full-time employees in 2019, you’re a small eligible employer. For 2021, that threshold increases to 500 or fewer.If you’re a small eligible employer:

• In 2020, all wages paid to employees qualify, regardless of whether they were working or not.
• In 2021, all wages paid qualify, up to that $10,000 per employee, per quarter cap.

Now, if you’re a large eligible employer (over 100 full-time employees in 2019 for 2020, over 500 for 2021), it gets a bit trickier:

• In 2020, only wages paid to employees for not working due to COVID-19 disruptions qualify.
• In 2021, same deal – just wages paid to employees not rendering services qualify.

Make sense? Let’s look at some examples to really drill it in.

Example: Small Employer in 2020

Say you own a restaurant with 10 employees in 2019. In 2020, you had to shut down dine-in services due to COVID-19 orders, but kept paying all 10 employees their full $40,000 salaries. Since you’re a small employer in 2020 with under 100 employees, all wages paid to those 10 employees qualify for the ERC, up to $10,000 each. That’s a potential $100,000 credit!

Example: Large Employer in 2021

Now let’s say you run a big retail chain that had 700 full-time employees in 2019. In Q2 2021, you had to furlough 200 employees who didn’t work that quarter, but you still paid them $5,000 each. As a large employer in 2021, only those $5,000 wages paid to the 200 furloughed employees count as qualified wages. That’s $1 million in potential credits for just that one quarter!But what if an employee worked a bit? No problem, any wages paid for time not rendering services still qualify.

Qualified Health Plan Expenses

Don’t forget, qualified wages also include qualified health plan expenses you paid for employees, like:

• Your share of health insurance premiums
• Amounts you paid for vision, dental, life insurance
• Amounts from employee pre-tax salary reduction contributions

Just make sure to document and allocate these costs properly when calculating your qualified wages.

Calculating Your ERC Amount

Once you’ve nailed down your qualified wages, calculating your actual ERC is easy:

• For 2020: 50% of qualified wages up to $10,000 per employee
• For 2021: 70% of qualified wages up to $10,000 per employee, per quarter

So for that small restaurant in 2020, with $100,000 in qualified wages, the ERC would be $50,000.And for that large retailer in Q2 2021 with $1 million in qualified wages for furloughed staff? A cool $700,000 credit!

Preparing for an ERC Audit

Now that you understand qualified wages and how to calculate your credit, let’s talk about preparing for when the IRS inevitably comes knocking for an audit. Documentation is key – you’ll need to have impeccable records showing:

• Your eligibility as an employer (suspension of operations, decline in gross receipts)
• Calculations of qualified wages for each employee
• Allocation of health plan expenses
• Final ERC calculations

Some good things to include:

• Employee pay stubs/ledgers
• Health insurance invoices
• Accounting of any work employees did (for large employers)
• Copies of COVID-19 orders that impacted your business
• Quarterly gross receipts comparisons to 2019

When the IRS Comes Calling

So the audit letter arrives – now what? Don’t panic. Respond promptly, and get all your ducks in a row.The IRS will likely request a ton of documents to substantiate your claim. Don’t go it alone – hire an experienced tax pro who knows how to properly respond and advocate for you. If issues do arise during the audit, you’ll want that expert by your side to:

• Explain any mistakes or missing documentation
• Negotiate to minimize potential penalties
• Lay out your strongest legal arguments

Remember, the burden is on you to prove your eligibility and accurate calculations. Having the right tax team in your corner could make all the difference.

Calculating Qualified Wages: Diving Deeper

What About Owner Wages?

If you want to claim the ERC on owner/self-employment pay, be sure to:

• Carefully document your calculations and legal reasoning
• Be prepared to make a strong argument if audited
• Consider getting an opinion letter from a tax expert

It’s a gray area, so tread carefully. Having the right tax team on your side is crucial.

Qualified Wages & PPP Loans

Here’s another tricky area – if you received a Paycheck Protection Program (PPP) loan that was forgiven, can you still claim the ERC on those same payroll costs?The short answer is no, you cannot “double dip” and use the same wages for both PPP loan forgiveness and the ERC. But, you may still be able to claim a portion of the ERC if you:

• Had payroll costs exceeding your PPP loan amount
• Paid wages both before getting the PPP loan and after the covered period

Let’s look at an example:Say your small business got a $200,000 PPP loan in April 2020. You used $150,000 of that on payroll during the covered period, and the other $50,000 on rent/utilities. For 2020, you had $300,000 total in qualified wages. You can’t claim the ERC on that first $150,000 of wages used for PPP forgiveness. But, you could claim it on the remaining $150,000 paid outside the covered period.

Allocating Health Insurance Costs

As we mentioned, qualified health plan expenses paid by the employer count as qualified wages for the ERC. But allocating and substantiating these costs properly is crucial. You’ll need to calculate the premium amounts paid for each employee during the periods you were eligible for the credit. This includes:

• Your share of health insurance premiums
• Amounts for vision, dental, life, disability plans
• Employee pre-tax salary reduction contributions

Having detailed pay stubs, insurance invoices, and a clear methodology for allocating these costs per employee is a must. Auditors will want to see your work. It’s also important to separate out any costs covered by premium tax credits, like for COBRA assistance eligibility. Those amounts can’t be counted twice.

Handling Severance Pay

Here’s one that might throw you for a loop – how do qualified wages get calculated if you paid severance to terminated employees?The IRS has stated that severance pay does qualify as wages eligible for the ERC. However, you can only claim severance paid during the specific quarters you were an eligible employer. For example, if you terminated employees in Q3 2020 but didn’t experience an eligibility event until Q4 2020, you couldn’t claim the ERC on that Q3 severance pay.You’ll need to carefully review termination dates and amounts paid to calculate qualified severance wages correctly. Having an employment lawyer or HR expert assist could be invaluable here.

Documenting Employee Work Status

Finally, let’s discuss the all-important task of tracking whether employees were actually working or not – a key factor in determining qualified wages for large employers. The IRS has provided some guidance on this, stating that employee time entry records, work logs, and documented assignments can all serve as acceptable proof of work status. But what if you didn’t formally track time for salaried employees? In that case, you may need to rely on other evidence like:

• Emails or communications about lack of work
• Payroll records noting “emergency pay” or similar
• Timesheets for hourly workers showing lack of hours

The key is developing a reasonable, consistently applied method for determining work status in each pay period. Auditors will be looking for that clear system in your records.You’ll also want to address things like:

• Employees who worked intermittently
• Staff who performed minimal services
• Paying workers more than they actually earned

Having robust documentation and policies around tracking work status could save you major headaches later.

When to Bring in the Pros

Look, there’s no sugar-coating it – calculating qualified wages for the ERC, especially as a larger employer, is insanely complex. Between segregating PPP costs, allocating health expenses, and tracking work status – it’s a lot. That’s why for any business taking a sizeable ERC, it’s wise to engage a qualified tax professional to:

• Evaluate your eligibility and calculations
• Advise on reasonable positions for gray areas
• Prepare workbooks and documentation
• Represent you in any audits or disputes

An experienced tax pro knows all the nuances of qualified wage rules. They can ensure you claim your maximum legitimate credit, while mitigating audit risk. The cost of their services is usually just a fraction of the tax savings you’ll realize. Not bringing in reinforcements could open you up to major headaches and potential clawbacks down the road. At the end of the day, calculating qualified wages correctly is the linchpin of your entire ERC claim. It’s not something to take lightly or handle on your own. Getting it right from the start could be the difference between a successful credit and a world of audit pain.

Qualified Wage Calculations: Lessons from the Trenches

They say experience is the best teacher, right? Well, when it comes to calculating qualified wages for the Employee Retention Credit, we’ve got some hard-earned lessons to share from the trenches. As tax professionals dealing with real-world ERC audits and disputes daily, we’ve seen all the potential pitfalls and snags businesses can run into. Let’s dive into some cautionary tales and key takeaways to ensure your qualified wage calculations can withstand scrutiny.

When Estimates Aren’t Enough

First up, a story that should serve as a wake-up call on the importance of rigorous documentation. We’ll call this client “Manufacturing Co.”Manufacturing Co. was a large employer that faced significant operational disruptions in 2020 due to COVID-19 shutdowns and supply chain issues. Like many businesses, they rushed to claim the ERC to get some relief. When calculating qualified wages though, they took some shortcuts. Instead of tracking actual hours and pay for non-working employees, they simply estimated the percentage of their workforce idled each pay period. On its face, their methodology seemed reasonable. But when the IRS auditor came knocking, it quickly fell apart under closer examination. The auditor demanded granular proof of which specific employees didn’t render services and for how long. Manufacturing Co.’s broad estimates didn’t cut it – they lacked employee-level documentation.In the end, the IRS allowed only a fraction of their originally claimed ERC amount. All because the company failed to substantiate qualified wages properly from the start.The lesson? Don’t take shortcuts or rely too heavily on estimates when calculating qualified wages. Maintain thorough payroll and time records showing each employee’s work status. It’s the only way to withstand IRS scrutiny.

Misunderstanding the Small Employer Rules

Here’s another qualified wage calculation mishap we frequently encounter – small employers misapplying the “all wages are qualified” rule. We’ll use “Local Restaurant” as our example. Local Restaurant had 75 full-time employees in 2019, making them a small eligible employer for the ERC in 2020 and 2021. The owners knew this meant all wages paid to employees counted as qualified that year. The issue? Local Restaurant assumed the same was true for 2021 as well. They claimed the ERC on all wages paid to their 75 employees across all four quarters of 2021.Unfortunately, that’s not how the rules work. While Local Restaurant was still considered a small employer in 2021 (under 500 employees), the “all wages qualify” provision only applied through Q3 2021.For Q4 2021, they should have only included wages paid to employees not rendering services in their qualified wage calculations, like large employers. Their blanket approach overstated their Q4 2021 ERC claim significantly. The IRS auditor quickly caught this error. Local Restaurant had to amend their claim and repay a portion of the credit, plus potential penalties and interest.

The takeaway? Don’t assume the small employer qualified wage rules remain static across all periods. Make sure you understand how that definition shifts, especially heading into Q4 2021.

Calculating Qualified Wages for ERC Audits